The materiality concept states that any transaction that can significantly impact the financial statements should not be ignored. It should be accounted for using the GAAP (Generally Accepted Accounting Practices) standards.
Put simply, all financial information that has the power to sway the opinion of a user of financial statements should be included in the financial reports.
The main question that needs to be asked is whether financial information makes a significant impact on the financial statements. If not, the company does need to fret about including it in their financial reports as it is immaterial.
Materiality is very subjective and can vary from company to company. Some information might be valuable to one company, but it might be too small for another larger company to worry about. It is therefore left upon the professionals to determine whether something is material or not based on their experience and good judgement.
The Securities and Exchange Commission (SEC) has recommended that an item constituting at least 5% of total assets must be disclosed separately in the balance sheet. However, even much smaller items can be considered as material and it will ultimately depend on the judgement of the company.
For instance, if a minor item has the impact of changing a profit figure into a loss figure, then it will be considered material regardless of how small the amount is. Similarly, if by including a transaction, a ratio that needs to comply with changes, it would be considered material.
Materiality Can Ignore Other Principles
The materiality concept can in essence override other principles of accounting. Accountants can choose to ignore other accounting concepts if it does not have an important effect on the financial statements of the company.
For instance, a company might choose to charge telephone utility expense in the books in the period that the cash is paid instead of charging it to the period in which the expense was incurred. This clearly violates the accrual principle and the matching principle of accounting. Accounting for a telephone bill on a cash basis is convenient and as per the materiality concept, we know that it will not cause a material difference in the financial statements.
What Constitutes Materiality
Materiality will depend on the subjective judgement of a professional. There are several factors that result in determining whether an item is material for a company to account for in its books. Some of them are:
Size of the Business
The size of a business is one of they key factors that determines materiality. Therefore, a $5000 amount for a small restaurant might be significant, but it will be immaterial for a larger organization such as IBM, Apple, Google, Tesla, General Electric, etc.
A specific item might be considered material based on the relative importance of it on the company’s financial statements. There is no specific limit available to determine the materiality of an amount. However, the general idea is that if it represents more than 2 % or 3 % of net income, it will be considered immaterial.
The accountant must take the combined effect of all the individual items as well. It might be possible that individually each item contributed less than 0.25% of net income, but when combined the impact of ten such items are around 2.5% or more. This will clearly require that these amounts be accounted for as material.
Nature of the Item
We have seen that materiality will depend a lot on the dollar amount, but it will also depend on the nature of the item or event. For instance, the company discovers that one of its managers has been siphoning off some money for personal use. Although, the amount may be insignificant and might not be more than a couple of hundred dollars, but that it was stolen will make it a material event to disclose on the financial reports.
General Rule of Thumb
Although there is no specific limit of materiality and can vary largely from company to company, a general rule of thumb is:
- On the income statement, an amount representing more than 5% of pre-tax profit or more than 0.5% of revenue is seen as a large enough amount to matter.
- On the balance sheet, an amount that is more than 1% of total equity or 0.5% of total assets is seen as a large enough amount to matter.
Materiality Concept Example
Let us study the case study below to get a better idea of how materiality can be determined.
A company reports an extraordinary loss of $50,000 related to the damages caused to its office building in the hurricane. In which of the below two scenarios will it be considered a material item?
- The net income of the company is $40,000,000.
- The net income of the company is $1,000,000.
Scenario 1 – Net Income: $40,000,000
|Loss to the company||$50,000|
|Net income of the company||$40,000,000|
|Materiality of item||0.13%|
In this scenario, we can see that the materiality of the extraordinary loss item is only 0.13% of the net income of the company, which is way below the rule of thumb of 5%. Therefore, it is not material and can be ignored.
Scenario 2 – Net Income: $1,000,000
|Loss to the company||$50,000|
|Net income of the company||$1,000,000|
|Materiality of item||5.00%|
In the second scenario, we can see that the materiality of the extraordinary loss item is 5% of the net income of the company, which is meet the rule of thumb of 5%. Therefore, it is should be accounted for as a material item.
Abuse of Materiality
Since neither GAAP nor IFRS specifically identifies the criteria for materiality, companies can easily abuse the grey lines provided. It is left to the auditors or the courts to review the cases of materiality abuse. They will need to study the motivation and intent behind the deliberate actions of the companies who have misused materiality principle.